Using Contracts to Deal with Unknowns: Part 1 “Known Unknowns”
Business people deal with unknown facts and circumstances in contracts all the time. Contracts allocate the responsibility for unknowns to one party or the other. Most often, this means cash out of pocket for a costly unforeseen event.
In this article, you’ll learn common ways to deal with two types of unknowns in a contract: the “known unknowns” and the “unknown unknowns.” Most people focus on the usual known unknowns, even though the unknown unknowns can have huge consequences. We’ll look at both.
For “known unknowns,” you can identify the general category of uncertainty, but not the outcome. You may know the probability of an outcome, or rely on experience or “gut instinct.” For example, if people are visiting a factory, the risky outcome is that “someone could get hurt.” Or, if you are buying some property, “the seller may not have all the necessary rights.”
In a contract, known unknowns can be addressed through representations, warranties, and indemnities crafted to cover the categories of risk you can identify.
A representation is a statement of fact from one party to the other party in a contract that the facts are true at a certain point in time. For example, you could make a representation to the other party that you own all rights to a piece of property on the date the contract is signed.
A warranty is an ongoing promise in a contract that stated facts will remain true in the future. For example, you could give a warranty that you will continue to own all rights to the property while the contract remains in force. In other words, you won’t sell the property during the contract term.
If a representation or warranty turns out not to be true, the party receiving it generally can terminate the contract, sue for damages or seek other remedies.
An indemnity is “a contract by which one engages to save another from a legal consequence of the conduct of one of the parties…. ” in the words of California Civil Code Section 2772. “To save another from a legal consequence” most often means that one party must defend a lawsuit (and pay attorney’s fees and damages awarded) if a third party sues the other party to the contract. For example, if you have a contract with another company and your employees visit the other company’s factory, then the other company could indemnify you against personal injury lawsuits by your employees if your employees are injured during the factory visit. For more, see the definition of “indemnity” at http://boadweelaw.com/glossary.
The continued existence of both parties is a known unknown. Business people often neglect these “existential” risks, especially in smaller contracts, but they can affect almost every deal. Some of these risks can be dealt with under contract law, and others cannot. Other law, such as bankruptcy, trusts & estates or even family law, may apply. A party may be sold to another company (change of control) , or may go bankrupt and out of business. Contract provisions can deal with the change of control (e.g., terminating the contract upon a change of control). Because bankruptcy law can override almost any contract, that law must be considered if a party may go out of business. If the other party is an individual person, you should consider the possible impact of personal bankruptcy, or severe disability or death (where trusts & estates or family law may come in). For example, personal risks are important in shareholder or partnership agreements. Other existential risks, such as seizure by a foreign government or significant new regulations, are more rare.
In the next issue, I’ll discuss how to deal with “unknown unknowns” in a contract.